In an article I wrote a few months ago, “Leveraging Economies of Scale – Manufacturing in the Price System,” I explained how the evolution of manufacturing efficiencies can create mass production savings at the factory floor. In this article, I will expand on the concept of “scale economies.” What is this term meant and how can it help us create mass productions that yield significant cost savings? The article will answer these questions and more.
“Leveraging Economies of Scale” is a phrase originated by John Kotter and Bill Powers in their book Think Tank Report (1979). The term was later adopted by McKinsey. The idea behind the “Larger Organizations are Embracing the Benefits of scale” concept is to recognize the benefits that can accrue from the implementation of small units of functionality in larger organizational units. This concept is often referred to as “internal economies.”
Internal economies refer to economies of scale that result from increased functionality and lower costs created by the implementation of smaller numbers of functionally related parts in larger numbers of larger units. Consider a pair of scissors. One unit has a handle and the other is without a handle. We all know that when you take out one handle, you reduce the number of scissors available to use by half. This would be a reduction in the number of scissors that are needed to complete a job, but only if the job was complex enough to require all the scissors.
In manufacturing, leveraging economies of scale occur when production is done at the factory and moved outside to a third party manufacturer where it is processed and packaged. Consider a set of products which are manufactured in one factory and sent to a wholesaler for packaging. The wholesaler receives the products, loads them into boxes and sends them on to various retailers for retailing. Assuming no further improvement in the products, over time each box of each product will accumulate small amounts of excess weight which need to be removed before being shipped to the retailers. In order to do this, a large conveyor belt is used.
The system described above is a perfect example of internal economies of scale. The manufacturers are sharing more of the initial input costs with the third-party provider. This is not always a bad thing as the manufacturer can pass on some of these cost savings to its customers. For example, if the manufacturer was able to reduce its labour costs by reducing the number of workers employed in a particular process, then an even greater share of those savings would be passed on to customers. External economies of scale are thus necessary when companies want to expand but don’t want to have to completely re-invent their businesses.
External economies of scale are important for companies that want to enter new markets but have limited or no experience in them. It is often difficult for smaller organizations to enter markets where they have less experience because they are overburdened with too many activities and tend to miss out on good opportunities. By leveraging economies of scale, smaller organizations can launch their products into markets where they have minimal experience without facing serious risks. Larger organizations can leverage their size to bring down prices. The two are often not mutually exclusive.
There are several other examples of leveraging economies of scale. For example, a company can save a substantial amount of money in the procurement of raw materials while at the same time maintaining competitive advantage. Companies also save money on setting up infrastructure by leveraging existing infrastructures and processes. They also save on labour costs by hiring professionals who specialize in particular tasks rather than hiring people who may have expertise in performing repetitive tasks. And finally, companies that realize the potential of complex technologies and systems can use these savings to develop new technologies that can bring further productivity and cost-cuts.
All these benefits occur when companies exploit the ability of their competitors to leverage internal economies of scale. By outsourcing certain processes or elements of the organization, they reduce the costs of running the business while increasing the efficiency of their operation. They also increase productivity by improving the quality of service provided to customers. And finally, by externalizing functions such as distribution, the companies make it easier for external third-party services to integrate themselves into their own process. By leveraging economies of scale, external suppliers and partners become more affordable. This allows them to compete in the market on price with established players.